Despite significant deterioration of business fundamentals, this firm has seen its share price rise over 30% year-to-date. Investors have bought into a growth story that not only fails to produce profits, but has proven false in the past. With growing losses, significant competition, and a highly overvalued stock, Yelp Inc. (YELP: $38/share) is this week’s Danger Zone.

Revenue Growth Doesn’t Reach The Bottom Line

[drizzle]Yelp’s economic earnings, the true cash flows of the business, have declined from -$28 million in 2012 to -$75 million in 2015 and to -$90 million over the last twelve months (TTM). Meanwhile, revenue has grown from $138 million in 2012 to $550 million in 2015, or 59% compounded annually, and even further to $629 million TTM. See Figure 1. See the reconciliation of YELP’s GAAP net income to economic earnings here.

Figure 1: Economic Earnings Fall While Revenue Rises

Sources: New Constructs, LLC and company filings

Yelp’s return on invested capital (ROIC) has fallen from 7% in 2014 to a bottom quintile -3% TTM. The company’s after-tax profit (NOPAT) margins have also declined from 7% in 2014 to -3% TTM. Lastly, Yelp has burned through cumulative $465 million in free cash flow since 2013.

Executive Compensation Plan Only Emphasizes Share Price

Executives at Yelp, apart from base salaries, receive short and long-term equity compensation. In some instances, such as the CEO, base salary is set at $1, and equity compensation is used instead. To bridge the gap between low salaries and the compensation of its peer group, the company uses a mix of equity awards that vest over four years, and awards that vest monthly for two years. Additionally, Yelp lists 40 separate metrics that its compensation committee can use to determine performance awards, including non-GAAP items such as bookings, billings, or user satisfaction. Yelp also lays out specific adjustments than can be made when determining performance goals such as excluding restructuring charges or the effects of stock based compensation.

With such a large portion of executive compensation tied to Yelp’s stock price, and monthly vesting schedules in some cases, management must consistently meet the market’s expectations to ensure they get paid. The “pressure to perform” could lead to exploiting accounting loopholes to manipulate earnings, which is more prevalent than most investors realize. Just as bad, acquisitions with terrible economics can grow EPS per the high-low fallacy. Lastly, incentives focused only on share price can lead to decisions that maximize short-term gains at the expense of long-term, sustainable cash flows, something we’ve witnessed before.

Companies with significant losses can use non-GAAP metrics in an attempt to paint the business in a more positive light. Yelp’s use of adjusted EBITDA and non-GAAP net income perfectly illustrates the dangers of non-GAAP metrics. Here are some of the expenses YELP has removed when calculating its non-GAAP metrics:

Stock based compensation

Amortization of intangible assets

Restructuring and integration

The removal of these costs allows Yelp to report growth in non-GAAP metrics despite economic earnings heading the opposite direction. In 2015, Yelp removed nearly $61 million in stock based compensation (11% of revenue), among other expenses, to turn a $33 million GAAP loss into a $29 million non-GAAP profit. In 2014, Yelp removed $42 million in stock based compensation, which was 116% of GAAP net income. Since 2013, Yelp’s adjusted EBITDA has grown from $29 million to $71 million TTM. Meanwhile, economic earnings declined from -$25 million to -$90 million over the same time and free cash flow has remained negative and sits at -$36 million TTM, per Figure 2

Yelp’s primary business is based around collecting advertising revenue from businesses. From a consumer perspective, Yelp’s service provides ways to discover new businesses as well as reviews of said businesses. Its ancillary services allow for reservations, food ordering/delivery, and quote requests from service businesses. Unfortunately for Yelp, it faces competition from every angle. Figure 3 lists many different competitors and how they stack up to Yelp. From reviews, to restaurants, to overall business listings, its clear that Yelp operates in a highly competitive market. Remove Yelp from the market, and any of the firms below would fill the void.

We do not think that being a digital version of the yellow pages makes Yelp’s business meaningfully stronger than the offline version of yellow pages. As we have stated about Netflix (NFLX), there is no sustainable value creation in businesses that are built around leveraging the Internet to deliver content. Just doing something over the Internet does not, by itself, create a viable business especially when it comes to content. The value, as it always has been, is in high quality original content. Consequently, we see Yelp as an undifferentiated distributor of commoditized content that will follow a similar lifecycle to the offline yellow pages.

Figure 3: Yelp Vs. Competition

Sources: New Constructs, LLC and company filings

Though many of these competitors focus on one subset of a market, or one service type (e.g. restaurants), this list, which includes firms such as Facebook (FB), Grub Hub (GRUB), TripAdvisor (TRIP), and Angie’s List (ANGI) is by no means exhaustive. Alphabet (GOOGL) remains a large competitor, with its search business and its own reviews. Additionally, local radio and newspaper outlets, not to mention firms not listed above, such as the Better Business Bureau, Thumbtack, Zagat or even Airbnb, whose city “guidebooks” contain local recommendations from travelers, further crowd the market.

Yelp’s quest to be a one-stop shop has left its profitability lagging the competition. Per Figure 4, Yelp’s NOPAT margin ranks well below advertising giants Facebook and Google, but also below firms such as TripAdvisor (TRIP) and GrubHub (GRUB). In a largely commoditized market, Yelp has little pricing power, an issue exacerbated by its already negative margins.

Trying to be all things to all people with respect to connecting consumers with businesses through search, reviews, and advertising has stretched the company’s operations thin and led to cash losses. Yelp does not appear to have staked a leadership position in any category. Nevertheless, bulls have overlooked the cash losses and weak competitive position and seem to be drinking the non-GAAP profit and revenue growth koolaid in the first two quarters of this year.

At some point, investors will be in for a bad surprise as costs have grown at an equal or greater pace than revenues. Since 2012, Yelp’s